Gary Gensler, an undersecretary of the Treasury, went to Capitol Hill in March 2000 to testify in favor of a bill everyone knew would fail.
Fannie Mae and Freddie Mac were ascendant, giants of the mortgage finance business and key players in the Clinton administration's drive to expand homeownership. But Gensler and other Treasury officials feared the companies had grown so large that, if they stumbled, the damage to the U.S. economy could be staggering. Few officials had ever publicly criticized Fannie Mae and Freddie Mac, but Gensler concluded it was time to urge Congress to rein them in.
"We thought this was a hand-on-the Bible moment," he recalled.
The bill failed.
The companies kept growing, the dangers posed by their scale and financial practices kept mounting, critics kept warning of the consequences. Yet across official Washington, those who might have acted repeatedly failed to do so until it was too late. Last weekend, the federal government seized control of the two companies to protect the very mortgage market they were created to lubricate. The cost to taxpayers could run into the tens of billions of dollars.
As policymakers now set out to decide what role government, and the two companies, should play in the mortgage business, the failures of the past two decades offer a cautionary tale.
Blessed with the advantages of a government agency and a private company at the same time, Fannie Mae and Freddie Mac used their windfall profits to co-opt the politicians who were supposed to control them. The companies fought successfully against increased regulation by cultivating their friends and hounding their enemies.
The agencies that regulated the companies were outmatched: They lacked the money, the staff, the sophistication and the political support to serve as an effective check.
But most of all, the companies were protected by the belief widespread in Washington -- and aggressively promoted by Fannie Mae and Freddie Mac -- that their success was inseparable from the expansion of homeownership in America. That conviction was so strong that many lawmakers and regulators ignored the peril posed to that ideal by the failure of either company.
In October 1992, a brief debate unfolded on the floor of the House of Representatives over a bill to create a new regulator for Fannie Mae and Freddie Mac. On one side stood Jim Leach, an Iowa Republican concerned that Congress was "hamstringing" this new regulator at the behest of the companies.
He warned that the two companies were changing "from being agencies of the public at large to money machines for the stockholding few."
On the other side stood Barney Frank, a Massachusetts Democrat who said the companies served a public purpose. They were in the business of lowering the price of mortgage loans.
Congress chose to create a weak regulator, the Office of Federal Housing Enterprise Oversight. The agency was required to get its budget approved by Congress, while agencies that regulated banks set their own budgets. That gave congressional allies an easy way to exert pressure.
"Fannie Mae's lobbyists worked to insure that [the] agency was poorly funded and its budget remained subject to approval in the annual appropriations process," OFHEO said more than a decade later in a report on Fannie Mae. "The goal of senior management was straightforward: to force OFHEO to rely on the [Fannie] for information and expertise to the degree that Fannie Mae would essentially regulate itself."
Congress also wanted to free up money for Fannie Mae and Freddie Mac to buy mortgage loans and specified that the pair would be required to keep a much smaller share of their funds on hand than other financial institutions. Where banks that held $100 could spend $90 buying mortgage loans, Fannie Mae and Freddie Mac could spend $97.50 buying loans.
Finally, Congress ordered that the companies be required to keep more capital as a cushion against losses if they invested in riskier securities. But the rule was never set during the Clinton administration, which came to office that winter, and was only put in place nine years later.
The Clinton administration wanted to expand the share of Americans who owned homes, which had stagnated below 65 percent throughout the 1980s. Encouraging the growth of the two companies was a key part of that plan.
"We began to stress homeownership as an explicit goal for this period of American history," said Henry Cisneros, then Secretary of Housing and Urban Development. "Fannie and Freddie became part of that equation."
The result was a period of unrestrained growth for the companies. They had pioneered the business of selling bundled mortgage loans to investors and now, as demand from investors soared, so did their profits.
Near the end of the Clinton administration, some of its officials had concluded the companies were so large that their sheer size posed a risk to the financial system.
In the fall of 1999, Treasury Secretary Lawrence Summers issued a warning, saying, "Debates about systemic risk should also now include government-sponsored enterprises, which are large and growing rapidly."
It was a signal moment. An administration official had said in public that Fannie Mae and Freddie Mac could be a hazard.
The next spring, seeking to limit the companies' growth, Treasury official Gensler testified before Congress in favor of a bill that would have suspended the Treasury's right to buy $2.25 billion of each company's debt -- basically, a $4.5 billion lifeline for the companies.
A Fannie Mae spokesman announced that Gensler's remarks had just cost 206,000 Americans the chance to buy a home because the market now saw the companies as a riskier investment.
The Treasury Department folded in the face of public pressure.
There was an emerging consensus among politicians and even critics of the two companies that Fannie Mae might be right. The companies increasingly were seen as the engine of the housing boom. They were increasingly impervious to calls for even modest reforms.
As early as 1996, the Congressional Budget Office had reported that the two companies were using government support to goose profits, rather than reducing mortgage rates as much as possible.
But the report concluded that severing government ties with Fannie Mae and Freddie Mac would harm the housing market. In unusually colorful language, the budget office wrote, "Once one agrees to share a canoe with a bear, it is hard to get him out without obtaining his agreement or getting wet."
'Big, fat gap'
Fannie Mae and Freddie Mac enjoyed the nearest thing to a license to print money. The companies borrowed money at below-market interest rates based on the perception that the government guaranteed repayment, and then they used the money to buy mortgages that paid market interest rates. Federal Reserve Chairman Alan Greenspan called the difference between the interest rates a "big, fat gap." The budget office study found that it was worth $3.9 billion in 1995. By 2004, the office would estimate it was worth $20 billion.
As a result, the great risk to the profitability of Fannie Mae and Freddie Mac was not the movement of interest rates or defaults by borrowers, the concerns of a normal financial institution. Fannie Mae's risk was political, the concern that the government would end its special status.
So the companies increasingly used their windfall for a massive campaign to protect that status.
"We manage our political risk with the same intensity that we manage our credit and interest rate risks," Fannie Mae chief executive Franklin Raines said in a 1999 meeting with investors.
Fannie Mae, and to a lesser extent Freddie Mac, became enmeshed in the fabric of political Washington. They were places former government officials went to get wealthy -- and to wait for new federal appointments. At Fannie Mae, chief executives had clauses written into their contracts spelling out the severance benefits they would receive if they left for a government post.
The companies also donated generously to the campaigns of favored politicians. The companies' political action committees and employees have donated $4.8 million to members of Congress since 1989, according to the Center for Responsive Politics.
But Fannie Mae wasn't just buying influence. It was selling government officials on an idea by making its brand synonymous with homeownership. The company spent tens of millions of dollars each year on advertising.
Even Greenspan, who shared the concerns of Treasury officials about the unrestrained growth of Fannie Mae and Freddie Mac, refrained for years from using his bully pulpit to urge action. He too wanted a hot housing market.
In tying itself to politicians and wrapping itself in the American flag, Fannie Mae went out of its way to share credit with politicians for investments in their communities.
"They have always done everything in their power to massage Congress," Leach said.
And when they couldn't massage, they intimidated. In 2003, Richard H. Baker (R-La.), chairman of the House Financial Services subcommittee with oversight over Fannie Mae and Freddie Mac, got information from OFHEO on the salaries paid to executives at both companies. Fannie Mae threatened to sue Baker if he released it, he recalled. Fearing the expense of a court battle, he kept the data secret for a year.
Baker, who left office in February, said he had never received a comparable threat from another company in 21 years in Congress. "The political arrogance exhibited in their heyday, there has never been before or since a private entity that exerted that kind of political power," he said.
In June 2003, Freddie Mac dropped a bombshell: It had understated its profits over the previous three years by as much as $6.9 billion in an effort to smooth out earnings.
OFHEO seemed blind. Months earlier, the regulator had pronounced Freddie's accounting controls "accurate and reliable."
Humiliated by the scandal, then-OFHEO director Armando Falcon Jr. persuaded the White House to pay for an outside accountant to review the books of Fannie Mae. The agency reported in September 2004 that Fannie Mae also had manipulated its accounting, in this case to inflate its profits.
The companies were humbled. The flaws of their business practices were laid bare.
The companies soon faced new bills in both the House and the Senate seeking increased regulation. The Bush administration took the hardest line, insisting on a strong new regulator and seeking the power to put the companies into receivership if they foundered. That suggested the government might not stand behind the companies' debt.
Fannie Mae and Freddie Mac succeeded in escaping once more, by pounding every available button.
The companies orchestrated a letter-writing campaign by traditional allies including real estate agents, home builders and mortgage lenders. Fannie Mae ran radio and television ads ahead of a key Senate committee meeting, depicting a Latino couple who fretted that if the bill passed, mortgage rates would go up.
The wife lamented: "But that could mean we won't be able to afford the new house."
Most of all, the company leaned on its Congressional supporters.
In the Senate, Robert F. Bennett (R-Utah) added an amendment giving Congress the ability to block receivership, weakening that bill to the point where the White House would no longer support it. Bennett's second-largest contributor that year was Fannie Mae; his son was then the deputy director of Fannie's regional office in Utah.
Fannie Mae even persuaded the New York Stock Exchange to allow its shares to keep trading. The company had not issued a required report on its financial condition in a year. The rules of the exchange required delisting. So the exchange created an exception when "delisting would be significantly contrary to the national interest."
The amendment was approved by the Securities and Exchange Commission. FNM would remain on the NYSE.
The final blow
As Fannie Mae and Freddie Mac were trying to recover from their accounting scandals, a new and ultimately mortal threat emerged. Yet again, the warnings went unheeded for too long.
The companies had begun buying loans made to borrowers with credit problems.
Fannie Mae and Freddie Mac had been losing market share to Wall Street banks, which were doing boomtown business packaging these riskier loans. The mortgage finance giants wanted a share of the profits.
Soon, the firms' own reports were noting the growing risk of their portfolios. Dense monthly summaries of the companies' mortgage purchases were piling up at OFHEO.
An employee at one of the companies said it was already a constant discussion around the office in 2004: When would the regulators notice?
"It didn't take a lot of sophistication to notice what was happening to the quality of the loans. Anybody could have seen it," the staffer said. "But nobody on the outside was even questioning us about it."
President Bush had pledged to create an "ownership society," and the companies were helping the administration achieve its goal of putting more than 10 million Americans into their first homes.
Fannie Mae and Freddie Mac's appetite for risky loans was growing ever more voracious. By the time OFHEO began raising red flags in January 2007, many borrowers were defaulting on loans and within months Fannie Mae and Freddie Mac would be running out money to cover the losses.
Finally, as the credit crisis escalated, Congress passed a bill two months ago establishing a tough, new regulator for the companies. It was too late.